U.S. Sandwich Structures in the International Inbound Context

When a foreign
multinational operates in the United States through
a U.S. group that has underlying foreign
operations—known as a “U.S. sandwich
structure”—repatriating the U.S. group’s foreign
earnings often results in tax inefficiencies. This
is because the after-tax foreign earnings may be
subject to multiple layers of income and withholding
tax as the earnings are repatriated up the ownership
chain from the foreign operating entities (the
controlled foreign corporations, or CFCs) to the
U.S. group and then to the foreign parent. U.S.
sandwich structures are also operationally
inefficient, as the interposition of the U.S. group
may prevent the foreign parent from achieving cost
savings and business synergies by eliminating
redundant sales and administrative functions,
consolidating plants, and cross-selling products and
services among the various operating units.

Out-from-Under Planning Techniques

To eliminate, or at least mitigate these
inefficiencies, foreign multinationals frequently
restructure their U.S. group such that the income
of the underlying CFCs inures to the foreign
parent or is otherwise earned outside the U.S. tax
net. In the past, this restructuring, sometimes
referred to as “out-from-under” planning, often
was accomplished through a parent-subsidiary
stock sale, whereby a foreign holding company of the
CFCs would check the box on the CFCs and sell them
to the foreign parent in exchange for stock of the
U.S. parent. Sec. 304(a)(2) treats the stock sale as
a dividend-equivalent redemption of the U.S.
parent’s stock. For foreign tax purposes, the
disposition of the U.S. parent stock may be largely
tax free, due to a basis offset and, in certain
countries, any resulting gain may be largely exempt
from local country tax.

Before the change in law discussed below, the
dividend-equivalent redemption amount was treated
for U.S. tax purposes as a dividend, first to the
extent of the earnings and profits (E&P) of
the acquiring foreign holding company and then to
the extent of the E&P of the U.S. parent. This
transaction removed the CFCs out from under the
U.S. tax net. It also resulted in the E&P of
the CFCs “hopscotching” around the U.S. group, as
the redemption amount was treated as
foreign-source dividend income for U.S. tax
purposes and thus not subject to U.S. withholding
tax. Checking the box on the CFCs before the
disposition would reduce the amount of any subpart
F inclusion to the U.S. group, and if the value of
the CFCs exceeded the E&P of the acquiring
foreign holding company, the acquisition of the
“hook” stock in the U.S. parent would not trigger
an income inclusion under Sec. 956.

To combat perceived abuses in this area,
Congress amended Sec. 304(b) on August 10, 2010,
as part of the Education Jobs and Medicaid
Assistance Act of 2010, P.L. 111-226. This new
provision, Sec. 304(b)(5)(B), provides that, in
the case of a stock acquisition by a foreign
corporation, the E&P of the foreign acquiring
company is not taken into account in determining
the dividend-equivalent amount if more than 50% of
the dividends arising from the stock purchase
would have been neither (1) subject to U.S. income
tax in the year of the transaction nor (2)
included in the E&P of a CFC. When this
provision applies, the E&P of the
foreign acquiring company is not eliminated, and
thus the hook stock in the U.S. parent may result in
an income inclusion under Sec. 956.

This
legislation significantly changed the means by which
foreign multinationals can reduce the potential
adverse tax consequences of a restructuring while
still resolving business inefficiencies associated
with their U.S. sandwich structures. Numerous
out-from-under planning techniques are still
available, one of which is discussed below.

Preferred Stock Freeze

The “preferred stock freeze” is not new but,
in light of the amendment to Sec. 304(b)(5), has
been in vogue lately. Rather than completely
removing the CFCs’ earnings from the U.S. tax net,
this tax planning technique limits the U.S.
group’s foreign earnings to an interest-like
yield. The earnings in excess of this
interest-like yield inure to the foreign parent or
another foreign affiliate that is subject to a
lower effective tax rate.

There are
numerous ways of structuring a preferred stock
freeze, each having its own advantages and
disadvantages depending on the group’s
organizational structure, the E&P and other tax
attributes of the group, and the value of the CFCs
relative to the other foreign entities involved in
the restructuring. While the structuring
alternatives vary, the overriding business
objectives are often the same: To integrate the
group’s operations, eliminate the number of
redundant legal entities, and create a more
efficient repatriation structure. Accomplishing
these business objectives in a tax-free manner often
presents a number of technical challenges, some of
which are discussed below.

Structuring considerations:The U.S. group and the foreign parent could
form a new foreign holding company that would
acquire the CFCs and other foreign operating
entities from the U.S. group and the foreign
parent, respectively. Assuming the foreign holding
company is a CFC, and the U.S. group enters into a
five-year gain recognition agreement, the transfer
of the CFCs should qualify for nonrecognition
treatment under Sec. 351. This planning technique
is effective because the ownership split is
structured in a way that maintains the controlled
foreign corporation status of the CFCs that were
transferred to the foreign holding company. Hence,
the transaction avoids triggering a deemed
dividend to the U.S. group under Sec. 367(b).
Rather, the CFCs’ E&P remains within the
transferred CFCs or within the foreign holding
company.

Depending on the tax profiles involved, it may
be more advisable to structure the transfer of the
CFCs as a B reorganization or as a D
reorganization by checking the box on the CFCs
after the transfer or actually liquidating the
CFCs into the foreign holding company. A
preexisting foreign subsidiary of the foreign
parent also could be used as the foreign holding
company. This, however, may make it more difficult
to satisfy the 80% control requirement for
nonrecognition treatment under Sec. 351.

To satisfy this control requirement, stock
previously owned by a transferor is taken into
account unless the stock received by such
transferor for the additional property transferred
is of a relatively small value when compared to
the value of the stock previously owned by the
transferor. Other structuring alternatives,
therefore, may need to be considered if an
existing operating entity must be used as the
holding company and the foreign parent is unable
to transfer more than a token amount of property.
For example, nonrecognition treatment still may be possible if the restructuring is effected through a D reorganization.
Alternatively, the foreign parent could transfer
the preexisting operating entity down below an
existing CFC that would serve as the foreign
holding company.

None of the structuring alternatives discussed
above would freeze the value of the U.S. group’s
interest in the CFCs if the U.S. group receives
common shares in the foreign holding company. This
is because the common shares would appreciate in
value as the combined business operation
appreciates in value. A freeze may be beneficial
to the U.S. group in that the U.S. group would
have less risk if the value of the investment
decreases. To achieve the freeze, the U.S. group
could receive preferred shares in the foreign
holding company or recapitalize its common shares
into preferred shares. If a recapitalization is
required, it is likely that the transaction would
qualify as an E reorganization, if an existing CFC
is used as the foreign holding company.

The preferred shares must be structured in a
manner that avoids the application of Sec. 351(g).
Otherwise, the nonqualified preferred shares
received by the U.S. group in the exchange will be
treated as boot and result in the taxable
disposition of the CFCs. To avoid application of
Sec. 351(g), the preferred shares should not carry a
redemption right or obligation that may be exercised
within 20 years, and the coupon rate should not be
tied to an interest rate or equivalent index, among
other criteria.

Depending on the anticipated
exit strategy, it also may be advisable to ensure
that the preferred shares are not classified as Sec.
306 stock. Were that the case, the amount realized
on certain dispositions of the preferred shares
would be characterized as ordinary income to the
extent the U.S. group would have received a dividend
had it received cash, rather than the preferred
shares, when the CFCs were transferred to the
foreign holding company. Such ordinary income would
not carry with it any Sec. 902 indirect foreign tax
credits, and any loss realized on the preferred
shares would not be recognized. Accordingly, in
certain circumstances, the sale of Sec. 306 stock
could result in ordinary income inclusion, without
the benefit of any Sec. 902 indirect foreign tax
credits, even though the shares were actually sold
at a loss.

Subpart F considerations: If
properly structured, the preferred shares will limit
the U.S. group’s interest in the foreign holding
company to a fixed, market-based return on the
preferred shares, thereby capping the amount of the
foreign holding company’s earnings (including the
income from the underlying CFCs) that is subject to
U.S. tax. The earnings in excess of the coupon rate
on the preferred shares, including any subpart F
income, will inure to the benefit of the common
shares held by the foreign parent. As a trade-off
for capping the amount of income subject to the U.S.
tax net, the U.S. group will be taxed on a current
basis each year as the dividends are paid on the
preferred shares. Such dividends, however, will
include a gross-up for the portion of the foreign
taxes paid on the underlying income, and thus the
Sec. 902 foreign tax credits associated with the
preferred dividends may further mitigate the U.S.
group’s tax exposure on the foreign holding
company’s earnings.

Conclusion

In the international
inbound context, U.S. sandwich structures make it
challenging to integrate operations, exploit
synergies, and efficiently repatriate the earnings
of the foreign operating entities to the foreign
parent. Despite the recent addition of Sec.
304(b)(5)(B) to the Code, effective planning
techniques still remain for dismantling these
sandwich structures in a tax-efficient manner. The
technical path, however, is challenging, and many
traps lie in wait. Careful tax planning is therefore
an essential ingredient in restructuring a foreign
multinational’s U.S. sandwich structure in a way
that accommodates its business objectives.

The authors would
like to thank Robert Stricof, the leader of
Deloitte Tax LLP’s Global U.S. Investment Services
group, and Robert Rothenberg from Deloitte Tax
LLP’s Washington National Office for their helpful
comments on this item.

EditorNotes

Jon Almeras is a tax manager with Deloitte Tax
LLP in Washington, DC.

For additional
information about these items, contact Mr. Almeras
at (202) 758-1437 orjalmeras@deloitte.com.

Unless otherwise noted, contributors are members
of or associated with Deloitte Tax LLP.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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